Don't worry about using leverage, the market always goes up by 10% per year
The number of people, institutions, etc... that got themselves into big trouble by levering up their portfolios on margin or whatever on over the past decade is truly amazing. I just found perhaps the most disturbing example of this yet yesterday...the State of New Jersey.
That's right, for years NJ has over-promised and under-funded retirement benefits to the unions who held its feet to the fire. Rather than taking the tough medicine and saying, look guys you're going to have to take less money than we promised you or actually funding its pension funds properly before the problem got out of control the state of New Jersey did what any logical investor would have done earlier this decade...they decided to lever up (that was sarcasm, which I realize is difficult to detect in the written word).
After falling behind on its pension obligations, here's what the geniuses who govern New Jersey decided to do:
Seeking to make up lost ground without putting up more money, the state's leaders looked to the magic of the stock market. In 1997 New Jersey sold $2.75 billion of bonds paying 7.6% interest, putting the proceeds into the pension fund to be invested for higher returns.
At that time Whitman said the ironically named Pension Security Plan would save taxpayers about $45 billion. It hasn't worked out that way. The fund has earned less than 6% annually since the bonds were issued.
"This is classically referred to as arbitrage," says U.S. Rep. Leonard Lance, a Republican who served in the New Jersey legislature from 1991 through 2008. "It's a questionable strategy in the private sector, and it's certainly not acceptable as a matter of public policy."
The lesson that one should take away from this mess, other than don't move to New Jersey (trust me I know) is that one should never, ever under any circumstances buy investments on margin no matter how tempting it is. I know, I know you're thinking "But this stock pays a 10% dividend and I can borrow on margin at 6%, that's a slam dunk." You're right, until something unforeseen happens and said stock is forced to temporarily or permanently cut its dividend. Buying on margin is E-V-I-L. Sure it can work and when it does it's great, but when it goes wrong it can be sooooo painful. Just ask Chesapeake Energy's CEO Aubrey McClendon about that. He saw his life's fortune wiped out by using margin. He has the luxury of forcing his board of directors to give him HUGE bonuses to make up his losses that you and I don't have.
The other thing that I take away from this article is that state pensions are a mess and that something that will have a negative impact upon consumer spending is going to have to give in the future. Either people who are due pensions in states like NJ are going to have to live on less money than they were planning on in the future or the citizens of states like this are going to have to pay higher state taxes on the future, or both. Either way, I don't see any way that this situation does not hamper U.S. growth at least somewhat going forward.
The public pension bomb